What is the correct method for govts and academics to financially analyze infrastructure projects, and why is this analysis method different from the way an investor or merchant banker would analyze it but without this creating a conflict or incongruity?
What we are talking about here is long-term infrastructure projects such as railways, district heat, roads, trams, telephone cables, bridges, canals, power cables, power stations, water pipes, reservoirs etc.
(Note governments use other additional methods of analysis which may or may not trump the economic analysis, and which include: political – the desire to support certain industries irrespective of economics, environmental, primary energy, exergy, corrupt self-interest, military & strategic, political, considerations etc.)
The first point to note is that none of these would get built if this were left to the free market as there would simply be too many obstacles and risks. Thus, no public railways would have been built without the government passing a law for EACH railway giving the developer the absolute right to plough through other people’s land paying minimum compensation and other rights and privileges not accorded to ordinary businesses. In other words, if the government wants infrastructure, it manipulates the marketplace in such a way that the investor’s return is guaranteed to a large extent providing he has done HIS sums correctly.
As per – “However, he added ‘a new era for nuclear power is by no means guaranteed. It will depend on governments putting in place robust policies to ensure safe and sustainable operation of nuclear plants for years to come – and to mobilise the necessary investments including in new technologies.’ ” – from https://www.routledge.com/Nuclear-Renaissance-Technologies-and-Policies-for-the-Future-of-Nuclear/Nuttall/p/book/9780367478070
Essentially when doing the financial analysis governments and academics look at the total capital and operating costs of a project over its lifetime as far as possible excluding taxes, profit, subsidies, etc i.e. they look at the nuts and bolts cost of buying the bits and pieces and then operating it over the lifetime.
If cost and economics were the only considerations, they would build the one with the lowest NPV based on 3.5% REAL discount/interest rates (i.e., excluding inflation). They would then consider the other non-financial factors listed above (which may trump the financial)
When they have picked on the infrastructure, they want …let’s say it is a public water and sewerage supply system say, rather than leaving it to people to collect their own water somehow and dispose of their own sewage somehow, they pass all sorts of laws to lower the risk and make it possible for an entity to undertake the project and build it.
These law changes might for example give the entity a total monopoly on supplying water or power, the ability to enter any property and place pipes without compensation, the right to construct vast sewers, the ability to charge and legally force the users to pay for it, and all sorts of other legal rights and immunities.
The same thing can be and is done with nuclear power stations even though they may not offer the cheapest solution – renewables may have a lower NPV.
What this then means is that money can then be lent to an infrastructure project by investors because it has been de-risked almost entirely by the government which then makes it very attractive – a secure long-term investment with guaranteed returns.
To guard against profiteering and price gouging, the govt will usually have some sort of regulator (which sadly often gets “ captured “ if the business is large and powerful enough)
Note that investors always look at, publicly discuss and report returns in terms of NOMINAL interest or rates returns i.e. the REAL return plus inflation.
So, the owner/investor of infrastructure if it is a private enterprise will only need to make a low rate of return because it is certain and effectively guaranteed by the government over the long term.
The owner and operator of the infrastructure – the bridge, railway, and water supply network will not itself build the bits of the infrastructure but will engage sub-contractor to providers and installers of the rails, the pipes, or dig the tunnels etc. The subcontractors will subcontract further the supply of pipes and rails.
All these contractors are now operating in a completely different environment ie the free market, without special de-risking laws to guard against the exigencies of the market and are therefore subject to all sorts of risks and forces beyond their control, therefore any money lent to them by investors is at a much higher nominal interest rate than that at which the project was originally analyzed, but without this creating any incongruity or inconsistency.
Let’s say they are a contractor and can borrow at 12% percent nominal due to the normal risks of the business, and this is the return the investors are hoping for on this project when they sign on the line and hand over the money.
In practice, they might get lucky and make this return or even exceed it on this occasion, but sometimes the contractor will overreach and go bankrupt, or not make the target return. Thus overall across all subcontractors, the rate of return for the whole of Britain’s economy is only about 3.5% – the number we first started with.
From David Olivier:
On Fri, 19 Aug 2022 at 11:31, David Olivier <email@example.com> wrote:
When I last read the government document (Treasury Red Book) it said that:
- 1.5%/y is the time value of money
- 2%/y is the economic growth rate
- giving a total of 3.5%/y
- the rate to use falls below 3.5%/y if the asset(s) will last for >30 y.
So, I assume that:
- Hydro and tidal power, or heat networks, are likely to apply a rate of slightly below 3.5%/y
- The rate is likely to be reduced in future, because economic growth seems more likely to be 0% than 2%/y.
David Olivier BSc MASHRAE
ENERGY ADVISORY ASSOCIATES
Lower Orchard House
- K., HR5 3LX
T (01544) 340647